Builder stocks bounce -- so why are CEOs still wary?

JohnSpence

(This is an update to correct the name of Pulte Homes Inc.'s chief financial officer.)

BOSTON (MarketWatch) -- After a brutal year that saw their industry fortunes decimated, the stock market is broadcasting signs of a turnaround in beleaguered home builders.

Housing-sector stocks -- left for dead just a couple months ago -- have been on a surprising tear recently.

An exchange-traded fund tracking the group, iShares Dow Jones U.S. Home Construction
ITB, +1.63%
closed Thursday up more than 20% over the previous three months.

'The spring selling season so far has been a letdown.'
Deutsche Bank analyst Nishu Sood

So why are so many market watchers, and even executives in the business, still so glum? Despite the recent run-up in builder shares, a number of imposing hurdles remain for the industry at the epicenter of the economy's mortgage-related earthquake.

Industry insiders are holding back from proclaiming a housing bottom until the market works its way through the huge overhang of unsold homes -- and until buyers feel more confident that a new house won't end up being worth less a month after they purchase it.

Even Toll Bros., which caters to affluent home buyers and enjoys one of the most recognizable brands in the industry, hasn't been immune to the housing downturn. This week the Horsham, Pa.-based company said it swung to a quarterly loss of nearly $100 million. Like other builders, Toll booked large write-downs on inventory and depreciating land assets.

Even though some markets are showing limited signs of recovery, "I'm not willing to say as of this call that we're back," Toll said this week. See full coverage.

More ominously, Toll's closely watched results for the January quarter suggest the key sales period that unofficially runs from Super Bowl Sunday to Memorial Day is off to another lackluster start this year.

"The spring selling season so far has been a letdown," said Nishu Sood, an analyst at Deutsche Bank.

'What we have to overcome is the feeling among consumers that to buy a house today is to catch a falling knife.'
Bob Toll, CEO of Toll Bros. Inc.

"Toll and other home-building stocks have rallied despite a worsening housing market, showing that investors are developing a clearer view of a second-half 2008 recovery," he said. "With home prices plummeting, we think it is too soon to make such a judgment."

'Bewildered' by a surge

Indeed, other observers have been baffled by the recent surge in home-builder stocks.

"There is no sign yet that the bottom is near; we look at the rally in home-builders' stocks in utter bewilderment," said Ian Shepherdson, chief U.S. economist at High Frequency Economics Ltd.

To back up his case, he pointed to the torrent of pessimistic housing data of late, punctuated by a fresh round out this week.

The Commerce Department reported that new-home sales fell about 3% in January to a 13-year low. Even worse, the inventory of unsold homes rose to a new cycle high of about 10 months, the largest since October 1981 and two-and-a-half times the average four-month supply witnessed during the housing boom.

Reflecting increased incentives that builders are offering to nervous customers, the median sales price fell more than 15% year-over-year in January, the biggest annual pullback in prices since the government began tracking sales in 1963. See full story.

"All these data are volatile and subject to hefty revision but there can be no doubt at all that the housing market is suffering a catastrophic collapse," Shepherdson said.

'Waiting on the sidelines'

To be sure, in housing downturns of the recent past, the builder sector has rallied before the housing market bottomed, most notably coming out of the correction in the late 1980s and early 1990s. The stocks have posted gains so far in 2008, even though new-home sales continue to sink.

Some argue that interest-rate cuts and the government's efforts to stimulate housing have for the moment overshadowed problems in the mortgage and credit markets, not to mention recession talk and surging oil prices.

Along with the inventory glut, builder CEOs say one of the biggest challenges is weak buyer confidence.

"Buyers are hesitant now. They're waiting on the sidelines for great incentives and further price reductions," Toll said this past week at an industry conference in Las Vegas sponsored by Wachovia. "What we have to overcome is the feeling among consumers that to buy a house today is to catch a falling knife," the CEO said. "We need to restore the feeling that this is not a depreciating asset."

When asked what leading indicator to watch to signal a housing recovery, Toll said cancellation levels, which he pegged at between 30% and 35% for the industry, need to stabilize and come down.

Tim Eller, CEO at rival Centex Corp.
M2500, -0.11%
also ticked off a list of signals that would telegraph a market bottom. They included a foreclosure spike, a slowing economy signaling a likely recession, a further pullback in housing starts, new-home prices correcting much faster than the resale market, a wider softening in land prices, and home builders reinvesting in real estate.

Clearly, he thinks things need to get worse before the housing market improves. "The market remains very difficult," Eller said.

Home-builder stocks traded sharply lower on Friday after rallying through much of the week.

'Hunker-down mode'

Jeffrey Mezger, who heads KB Home
KBH, +3.15%
predicted a continuing tough market in 2008. In his sights: Excess inventory of new and existing homes, sagging confidence, subprime-mortgage turmoil and still-stretched affordability.

KB Home has already cut home prices in anticipation of more weakness, and to compete against the resale market.

"Until prices stabilize and consumer confidence returns, we will continue to see inventory levels that are out of balance with demand," Mezger said.

"Recently, traffic has improved but it's too early to forecast any real rebound," said Jeffrey Orleans, CEO of Orleans Homebuilders Inc.
OHB, +1.13%
who also was at the Wachovia conference with Toll.

Although the builder remains in "hunker-down mode," business has picked up greatly from December and January, when sales were "dismal," he said.

"We think there are challenging times ahead," added the company's chief financial officer, Garry Herdler. "While it's too early to tell, we haven't seen the winter selling season as robust as we'd like it."

Some CEOs, such as Donald Tomnitz at industry giant D.R. Horton Inc.
DHI, +2.10%
were more sanguine.

"We are happier campers today than we were 60 days ago," he said, partly as a result of improving sales trends the past month. "I'm smiling," Tomnitz said.

"In the last several weeks, we've noticed a little bit of increased enthusiasm in sales activity across the company," said Stephen Scarborough at Standard Pacific Corp.
SPF, +0.00%
although he's said it's still premature to predict how the spring season will shake out.

"We all felt like we came out of the box a little sluggish in January," Scarborough said. "I think things have picked up a little bit [since then]."

Still, he's firmly in the camp that the biggest obstacle is weak consumer confidence.

"There are buyers in the marketplace; I think they are shopping," he said, even though many customers expect more price reductions. "It's challenging to get them to step up to the plate," Scarborough said.

Even though he's seen encouraging signs the last few weeks, it's "not notable."

"I don't have any great news for you yet," said Gordon Milne, Cregg's counterpart at Ryland Group Inc.
RYL
Although he thinks some markets are "getting better," this year will be far from easy. "We need to get pricing power back again," Milne said.

Like other builders, Ryland has scaled back its workforce in an effort to cut costs. Its total headcount is back at around 1999 levels of roughly 2,000 workers, down from a peak of more than 3,000 in 2006.

Adding to the woes, builders facing liquidity pressure have had to renegotiate terms with their bankers. Some companies are focused on quickly turning over inventory to generate cash and reduce debt and leverage.

'High-risk players only'

Although home-builder stocks have been knocked down to bargain-basement valuations, it's not clear if they've bottomed yet. Some analysts who've recommended dipping a toe in the shares over the past year have been burned as the stocks continued to fall before their recent snapback.

The question, of course, is whether this is a suckers rally or that a legitimate bottom has yet to be reached.

Those who worry that there's more pain to come cite the length and euphoria of the decade-long housing boom that ended with the bubble popping in 2005.

He said inventory data, which are the key metric in the outlook for housing, are getting worse. The recent rally in home-builder stocks was driven in part by efforts in Washington to rouse the housing market, and also short-covering by hedge funds and other traders that have bet heavily against the sector, he said.

"There is no fundamental reason to be a buyer [of builder stocks]," Puryear said. "It's for high-risk players only right now ... and a very tricky environment for these stocks."

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